New York, NY – According to a story broken last week on the Fox Business Network, Charlie Gasparino reported that sources are informing him that “there is essentially a war on hedge funds” and that the US Justice Department is trying to “set a major example of the trillion dollar hedge fund industry” with its insider trading probe. The following blog will try to lay out the various issues in the developing battle.
Gasparino went on to explain the importance of the growing insider trading investigation in his report. “Sources in Washington and New York are saying there is essentially a war on hedge funds from the Justice Department. The Justice Department wants to set a major example here in the trillion dollar hedge fund industry and their plan is to take down as many as a dozen hedge funds that are involved in this investigation. Shut them down or at least severely alter their business practices. They believe hedge funds have had an unfair advantage in the markets.”
Initially the DOJ’s investigation seemed to be focused on allegations of extensive insider trading, which some have billed as potentially the largest insider trading probe in US history, with federal officials examining multiple, organized insider-trading rings which might have reaped illegal profits of tens of millions of dollars.
Traditionally, insider trading has taken place when someone buys or sells a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.
Information is considered “non-public” if it has not been broadly and publicly disseminated for a sufficient period to be reflected in the security’s price. Information remains “non-public” until it has been “publicly disclosed,” meaning that it has been broadly distributed to the public in a non-exclusionary manner, such as via a press release or the inclusion of such information in a Form 8-K, 10-Q or 10-K filed with the Securities and Exchange Commission (“SEC”).
Information is considered “material” if a reasonable investor would consider it important in making a decision to buy, sell or hold securities. Information that is likely to affect the price of securities is almost always “material.” Either positive or negative information may be “material.” Some examples of Material Non-Public Information might include, but are not limited to:
- Financial results and financial forecasts;
- Sales and revenue levels;
- Significant new product developments;
- Gain or loss of a substantial customers or suppliers;
- Possible mergers, acquisitions, joint ventures and other purchases, sales or investments in companies or other entities;
- Purchase or sale of significant assets, including divestitures and acquisitions of a product line or division;
- Major financing developments, including establishment of bank lines and offering of additional debt or equity securities;
- Changes in senior management;
- Declaration of a stock split or stock dividends, or adoption of or changes to a stock repurchase program and the timing of repurchases under such a program; or
- Pending litigation.
Some industry observers have gone so far as to argue that insider trading has become a pervasive, systemic issue, rather than a case of a few bad apples. This is consistent with Manhattan US attorney Preet Bharara’s warning a few months ago that “illegal insider trading is rampant and may even be on the rise.” Certainly the belief that hedge funds are regularly engaged in the acquisition of material nonpublic information and trading on that information is the basis of some feeling that hedge funds have an “unfair advantage” in the markets.
An important aspect of the current insider trading investigation has been buy-side investors’ purported use of “expert networks” to obtain material nonpublic information.
“Expert networks” can be loosely defined as firms which have established a group or network of people who can, for a fee, be contacted to conduct any sort of professional research. The sources of information in these networks can be anyone from doctors, accountants, academics, engineers, scientists, or any type of working or retired professionals. Users of expert networks can range from mutual fund or hedge fund investors, consultants, private equity, corporate strategy, or product development executives.
The users of “expert networks” connect directly with primary information sources and industry experts to ask specific questions of in order to better understand the issues or topics they are interested in learning more about. In addition, users benefit from the compliance practices, procedures, and tools adopted by some of the more forward thinking expert network providers. Based on proprietary research collected by Integrity Research Associates, there are approximately 40 expert networks currently in existence.
Clearly, some industry observers have gone so far as to say that expert networks encourage or provide a motivation for experts to leak material nonpublic information to investors (or provide a tool for hedge funds to ferret out inside information from experts). We believe the evidence does not support this contention as most experts are paid on average $350 to $450 per hour (less than this if you consider that most consultations last only 30 minutes). We highly doubt that most experts would risk prosecution for this paltry sum of money.
However, expert networks have not gone unscathed in the current insider trading investigation. Last Wednesday the government charged Don Ching Trang Chu, an executive at Mountain View California-based expert-network Primary Global Research, with conspiracy to commit securities fraud by arranging for insiders to provide material, nonpublic information to his firm’s hedge funds clients. Mr. Chu’s relationship with Primary Global Research has subsequently been “severed” based upon recent events.
Channel Checks and Other Types of Primary Research
Surprisingly, the government has shown significant interest in potentially limiting other types of investment research practices used by buy-side investors, including conducting channel checks. In fact, one of the independent research firms apparently approached by the FBI, Broadband Research, conducts channel checks in the technology industry.
Channel checks involves analysts – either directly, or by using third-party expert networks or specialist channel research providers – calling suppliers, clients, purchasing managers, and manufacturer’s representatives to collect information regarding the prospects of a particular business.
Ultimately, this type of research requires analysts to collect various pieces of nonpublic information, which by themselves are not material, but which when put together can provide investors with a unique view of a company which an investor can make an investment decision based upon. This has traditionally been called the “mosaic theory”. A majority of sell-side and buy-side analysts have based their entire investment research approach on the legitimacy of the “mosaic theory”.
In the past, this type of investigative research was considered safe from insider trading charges. However, some believe that the DOJ is trying to expand the definition of insider trading to prohibit this type of research because they see that it promotes an unlevel playing field which only certain investors can benefit from.
A new aspect of the current insider trading investigation has been the use of soft dollar commissions to pay for access to experts.
SAC Capital Advisors, a $12 billion Greenwich-based hedge fund, told clients this past week that federal authorities appear focused on soft-dollar payments. SAC said it was basing that impression on a subpoena the firm received Monday afternoon, which it called “extraordinarily broad.”
One of the reasons that soft dollars has become a part of the insider trading investigation is because prosecutors must show that tippers receive a direct or indirect benefit for providing this information. Consequently, tracking how buy-side clients pay for their information would be critical to the case – including their use of soft dollar commissions.
Some suggest that the use of soft dollars might show criminal intent if asset managers were believed to be purposely obscuring their payments by routing them through their brokers rather than by paying for access to the experts directly.
Chill to the Independent Research Industry
One obvious consequence of the current insider trading investigation is a potential chill in the independent research industry as buy-side investors try to come to terms with what types of research are safe from accusations of insider trading.
According to Integrity Research Associates’ estimates, approximately 1,250 independent research firms are currently in existence. These independent research firms generated close to $2.6 billion in overall revenues in 2009. Based on our analysis, almost $600 million in revenue could be at risk if investors decide to limit their use of primary research due to uncertainty over what type of research is acceptable to US regulators.
As you might expect, some expert networks we have spoken with have already received calls from clients suspending their use of their services. In addition, some buy-side investors have also put a halt on hiring third-party channel check providers until the dust settles with this investigation.
We suspect that most buy-side clients will eventually resume their use of these types of research services once they are comfortable with their own compliance policies and once they have fully vetted the compliance practices of their respective research partners. However, we also think some investors will decide to reduce potential legal and compliance risk by banning the use of expert networks and/or channel check providers altogether.
Even if the current insider trading investigation finds that the use of expert networks and channel checks are completely acceptable forms of research, some independent research firms may find the commercial disruption to their businesses to be impossible to rebound from.
Off the Reservation
We contend that investors or experts intent on trafficking in insider information are less likely to use bona fide expert networks than they are to arrange this communication “off the reservation” through private means. The reason for this is that in the past five years most expert networks have established extensive compliance practices that restrict what and how their users and experts can use their services.
In fact, all of the material nonpublic information that Raj Rajaratnam is accused to have collected and traded on in the Galleon case is reputed to have been collected via his own personal network of contacts.
Rajaratnam didn’t use a formal expert network like GLG, Guidepoint or Coleman Research because these research firms would have kept an audit trail of each of these conversations, outlining the experts spoken to, the date of the conversations, the amount paid, and the general topic of the engagements. In other words, using these expert networks would have made it easier for the government to make an insider trading case against him.
As strange as it may seem, in today’s connected world finding insightful experts to speak with is not terribly difficult to do given various social media sites like LinkedIn, Facebook, or industry specific communities like TechDirt or Sermo. Given the alternative of having investors use professional expert networks with extensive compliance practices versus using their own personal networks with no compliance policies – the team at Integrity would recommend that regulators promote the use of formal expert networks.
Reduce Market Efficiency
One likely consequence of the government’s battle against the way hedge funds conduct their research is that it will dramatically reduce the efficiency of the markets. Historically, most buy-side analysts do extensive due diligence and primary research to build up a mosaic comprised of pieces of nonpublic information that any other highly motivated investors could also collect through equal dedication and resources.
Once these hedge funds are confident that their thesis is supported by the primary research they have conducted, they invest on this information. This means that the price of the specific stock they invested in would better reflect all of the relevant information that is available, thereby more closely representing the true intrinsic value of the company.
However, if the government gets its way and it eliminates a hedge fund’s ability to conduct legitimate primary research, then a company’s stock price will not reflect the best information possible about its business prospects. Consequently, all investors – including retail investors – would be subject to increased volatility and price shocks as real information about the company is released into the market.
Another problem with eliminating how investors conduct legitimate research is that it ultimately means that investors will have to rely more on the guidance provided by company managers, with little information to challenge their conclusions.
As we have seen countless times in the past, whether it is with Enron, WorldCom, Lehman Brothers, or the subprime mortgage crisis, investors were much better off for having done their own rigorous research rather than relying on the optimistic pronouncements of company management.
The war that Charlie Gasparino reported the DOJ had waged against hedge funds is likely to have a number of consequences. On the one hand, this war is likely to unearth some legitimate market abuses by individuals, and in some instances by entire firms that have proactively sought out and traded on material nonpublic information. It could also reveal some current practices that increase the likelihood for these types of abuses in the future.
However, unless conducted in a thoughtful manner, the DOJ’s war on hedge funds is also likely to have significant unintended consequences for a wide range of financial market participants including independent research providers, sell-side research departments, buy-side analysts, pension funds, and retail investors.